If you’re wondering if a crash like last Monday’s will happen again after the recent spate of volatility, the short answer is, “Yes, a crash like this will happen again.” The cause may not be the same, but the dominance of algorithmic investing (computer-trading) and popular financial products, which are so complicated that very few investors understand them, will certainly create crashes like this again.
Although the next time will likely be different, understanding what probably caused this week’s shock will help traders plan more effectively in the future.
What Drove the Crash?
To be clear, this isn’t a situation where we know for sure what triggered the initial decline, but what turned it into a crash looks very likely to be an implosion in certain exchange-traded funds (ETFs). Specifically, some exotic exchange-traded notes (ETNs) — which are a little different than ETFs — based on the S&P 500 Volatility Index futures seem to be the primary culprits.
The VIX is a measure of investor expectations for volatility and represents a pretty close approximation to the average level of implied volatility in the options of the S&P 500. When it rises, stocks fall and vice versa. This inverse relationship with stocks is very tight, but not perfect. There are times when investors get nervous about the potential for future volatility and push the value of the VIX futures higher even while stock values are rising.
As you can imagine, if a large trader sees VIX futures rising near the end of the day, they can do two things to hedge: 1.) short stocks, or 2.) go long VIX futures. On most days, if traders need to neutralize their portfolios at the end of the day, it won’t make a big impact on the market because not everyone agrees on the same short-term forecast, so buying and selling can remain stable.
Last week was different. An organic balance didn’t appear, a selling feedback-loop took hold and the market sustained a nasty shock.
The 900-lb Gorilla
In a normal market, investors are widely distributed and can do a lot to offset each other’s expectations. There is usually a bias in one direction or the other, which creates trends and normal price fluctuations, but a large group of unrelated buyers and sellers tends to smooth things out.
However, imagine that a massive VIX futures-buyer appears and creates a huge imbalance. To attract enough sellers, this VIX-buyer will have to continue paying higher and higher prices to get their positions filled. That is very similar to what happens in a short squeeze.
Eventually, other traders who would otherwise not have purchased VIX futures (or shorted stocks) may be forced to do so in order to neutralize their portfolios, which further throws the big VIX-buyer out of balance, and the feedback loop continues.
Last week, the big buyers were VIX ETNs, and it was enough to trigger the feedback loop of VIX-buying and stock-selling. A significant part of the problem wasn’t even that the VIX ETNs were all that large. Rather, it was the fact that everyone knows how those funds must be managed. At a certain point, those ETNs will have to make portfolio adjustments, and traders rushed in to get ahead of them. While the 2015 flash crash was different, an ETF arbitrage selling-frenzy was a large part of the reason it got so bad as well.
The former will be shut down later this month, and it is uncertain how long the ProShares version will last. You can see a chart of how much value the VelocityShares version lost during the debacle.
These funds have been favorites among traders who have profited from a long-term decline in volatility, but that decline also created one-sided risk that hit the market on Monday.
Were There Any Warning Signs?
Long periods of low volatility, selling by pension funds and a divergence between the VIX indicator and stocks in January were all key warnings signs that a crash could happen. However, it’s important to remember that two-thirds of the time, these signals are false alarms. If a crash happens, those signals almost always immediately precede it, but the failure rate can lead to complacency.
This is a little discouraging, but it is part of the price of taking risk in the market. Warnings signs are important, but traders can’t jump out of the market every time they see rising uncertainty. We must keep this balanced view in mind because flash crashes, like we saw last week and what continues this week, are likely to appear again in the future.
While the crash was discouraging, the market and the economy are two different things, and the underlying fundamentals are still very good. We remain optimistic about the bull-trend, but volatility will likely rise from here. From an option-trader’s perspective, this isn’t a bad thing. Rising volatility will make calls and puts more expensive, but it also increases the potential for bigger, short-term gains.
You can learn more about identifying price patterns and using them to project how far you think a stock is going to move in our Advanced Technical Analysis Program.
InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here.